Looking Only at Nominal Rates Leads to Poor Decisions
Even if a bank's time deposit advertises 0.3% annual interest, when inflation is running at 2% your real purchasing power is shrinking by 1.7% every year. The nominal interest rate is the face-value rate that ignores price changes. The real interest rate, by contrast, is the "true yield" after subtracting inflation. The Fisher equation approximates this as: real interest rate ≒ nominal interest rate - inflation rate.
In early 1990s Japan, nominal rates exceeded 5%, but with inflation at 1-2%, real rates were a healthy 3-4%. After the zero-interest-rate policy was introduced in the late 1990s, nominal rates plummeted. As of 2023, major bank savings rates sit around 0.002% while inflation has exceeded 3% in some periods, pushing real rates to nearly negative 3%. Simply holding deposits means your real wealth erodes by about 3% per year.
Evaluating Investment Products with Real Interest Rates
Even if a mutual fund shows a past return of 8% per year, if inflation over the same period was 2%, the real return is roughly 6%. When investing in foreign assets, you must also factor in the inflation rate of the target country and currency fluctuations. A 10% nominal return on US equities may look impressive, but if yen depreciation has inflated the figure, the real return in yen terms may not be as high as it appears.
The concept of real interest rates is especially critical for bond investing. Introductory books on bond investing explain how inflation-linked government bonds directly provide a real yield and serve as an inflation hedge.
Defending Your Assets in an Inflationary Era with Real Rate Awareness
In an environment of negative real interest rates, keeping assets in cash or low-interest deposits is itself a risk. To earn returns that outpace inflation, diversifying into real assets such as equities, real estate, and commodities is effective. Over the past 100 years of US data, equities have delivered a real return averaging 6.5-7% per year, far exceeding inflation.
When considering asset allocation, it is essential to compare real returns rather than nominal ones. Books on inflation hedging and asset protection introduce portfolio construction methods based on real returns.
How to Reassess Your Asset Allocation Using Real Rates
When real interest rates are negative, it is rational to minimize the share of savings deposits and increase allocation to inflation-resistant asset classes. A practical approach is to keep 6 months of living expenses in a savings account and direct the rest into equity index funds and REITs (Real Estate Investment Trusts). Over the past 30 years in Japan, equities have delivered a real return of roughly 4-5% per year, far outpacing deposits.
As a next step, subtract the inflation rate from the nominal return of your portfolio to calculate your real return. If any asset shows a negative real return, it may be time to reconsider your allocation. A compound interest calculator makes it easy to project future asset values with inflation factored in.